We are economists writing about economics: Karl Smith, an assistant professor of economics and government at the School of Government at the University of North Carolina; and Adam Ozimek, an associate at an economics consulting firm. As most in our profession are eager to tell you, economics includes just about everything, so we'll be blogging -- with varying degrees of success -- about the economy, markets, politics, science, technology, philosophy and culture. We both come from a similarly vague libertarian ideological perspective, but we've been called neoliberal as well, and idiosyncratic might be the best adjective to use.

What The Sharp Rise In Real Interest Rates Means For The US Economy

US real interest rates have suddenly turned northward, shooting straight up through zero, at a seemingly accelerating pace.

For me, analysizing the situation is a bit awkward. This is exactly the pattern that I expected roughly this time last year: housing markets would begin to cure rapidly, local governments would start running surpluses, auto sales would hit records and the US economy would accelerate out of the liquidity trap. Only it didn’t happen. Car sales went along more or less as expected, but every other feature disappointed. Housing stalled and state and local governments were still struggling to close budget gaps.

Its tempting just to tell the same story over, but non-blogging concerns have prevented me from staying steeped in the data as I would like and I’m not confident in that story. What we can is that the broad outlines point to a “savings shortage” in the US. That term is way more loaded than I would like but there is no other quick and accurate way to say it. Hopefully, I can ease some the burden on those words by noting a “saving shortage” could come from folks saving less or folks investing more. At the end of the day savings and investment have to more or less equal one another, so more borwers looks very much like few savers.

What makes us think this is whats going on.

Well, the real interest rate is going up – that’s one clue. Still, this alone is ambiguous. It could mean a higher risk premium on US bonds.

The dollar, however, is surging as well. That suggests that the rise in real interest rates is attracting evermore foreign investors in the US, not compensating for a lack of foreign interest.

Now, we could just say that the Fed is looking to tighten (loosen less aggressively?) monetary policy with the so called “taper.” That’s fine as far as it goes, but its fairly weak tea. If the fundamentals of the economy were the same as they were two years ago then tightening monetary policy would only lead to a slower recovery, weaker demand, falling inflation. In response the Fed would simply loosen again, only now with a damaged economy. When all is said and done that should produce lower real interest rates, not higher.

So perhaps the fundamentals are sharply improving – we are indeed bursting through the liquidity trap. Then we might expect higher profits as well. After all, the Fed is only raising rates because things are even better than expected. Yet, while the stock market as been on a tear this year, its faltered recently. This gives us pause about a sudden boost in expectations about corporate business conditions.

By process of elimination then we are left with roughly two broad possibilities.

2) A large expected decrease in household savings presumably as consumption rises. However, that consumption is not coming from increased exports or it would put downward pressure on the dollar. This would be an increase in domestic consumption. However, not a an increase that’s strong enough to raise inflation expectations.

The first seems plausable, of course, but why now especially. These trends have been visible for quite some time.

I am more inclined to think in terms of the latter and that in particular we may be seeing a supply-side boost from easing commodity prices. A casual look across the board at energy, primary metals, petrochemicals and agricultural yields suggests that such a boost is a upon us. Moreover, the likely slowdown in demand from China will exacerbate that supply. That means rising real wages, which in turn could drive down both precautionary savings.

In that scenario we would expect to see the labor force rise and unit labor costs to accelerate, but overall cost growth to be mild because declining materials costs. This would feel similar to the boost that the US got in the late 90s when Asian growth fell off a cliff and commodity prices tumbled.

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